Facing the fund tax challenge

SamMamudi

NEW YORK (MarketWatch) -- Many mutual fund investors are about to find out how it feels to have insult piled on top of injury.

Fund shareholders are facing the double whammy of negative returns plus, at some funds, a tax bill caused by fund managers unloading assets to cover redemptions. Along with swallowing average losses this year approaching 50% on all stock funds, some fund investors will get year-end capital-gains distributions on which they'll have to pay 15% tax.

"It's going to be the January surprise for a lot of people," said Larry Glazer, founder of Mayflower Advisors, an investment advisory firm in Boston.

Still, there's a potential benefit from the unwelcome tax news: It may prompt investors to think more about fund-related taxes at a time when the topic is likely to increase in importance. That may include pursuing a smarter tax strategy or seeking out more tax-efficient funds, such as index funds, exchange-traded funds and tax-managed funds.

And higher-income investors may need to pay more attention to fund taxes if, as expected, the top tax rate on capital gains eventually rises under President Barack Obama.

While investors can realize capital gains when they sell their fund shares, they can also be liable for gains tax even if they do nothing. This is because mutual funds are pass-through entities. That means the tax liabilities that a fund's manager incurs by selling securities for more than the purchase price aren't charged to the fund but, rather, are passed along to its shareholders.

By law, funds must distribute their net realized capital gains each year. Shareholders who hold their fund shares in taxable accounts owe any taxes due on those distributions, even if they roll the money back into the fund to buy additional shares. And even in a year like this when most stocks have declined in value, some managers have sold stocks at prices above what they paid years earlier.

It's important to note, though, that the cost facing investors of funds' capital-gains distributions isn't as great as it may seem at first glance. The tax you pay now will either reduce the tax you owe when you sell your fund shares at a gain or increase your loss for tax purposes. Still, paying taxes sooner rather than later is the opposite of what you should be striving for, and robs a portfolio of the benefits of compound interest.

And while fund investors don't get an immediate tax benefit when a manager sells portfolio securities for a net loss, it can help them in the long run. Funds can carry those losses forward for as much as eight years and use them to offset realized gains in those later years.

Say a fund realizes net losses of $100 million one year and in the next year realizes a net profit on securities sales of $80 million. Instead of being forced to distribute the $80 million in taxable gains to investors, the fund can use its tax-loss carry-forward to absorb that gain.

Expected distributions

It's not yet clear how many funds will pay capital-gains distributions this year. The industry typically pays out in December, but some funds announce their distribution estimates in November. Longleaf Partners Funds was one of the first fund groups to announce that some of its funds will be distributing gains. In its statement detailing the distributions, Longleaf said, "In a down year receiving a taxable distribution can feel like a double insult."

Vanguard Group, Fidelity Investments, Franklin Templeton Investments, a unit of Franklin Resources
BEN, +1.51%
and Invesco Aim, the mutual fund arm of Invesco Ltd.
IVZ, +2.06%
are among other firms that have announced capital-gains payouts this year. Their energy and international funds, especially emerging-markets ones, are making the biggest payouts.

Christopher Davis, fund analyst at Morningstar Inc., said Templeton Developing Markets
TEDMX, +0.57%
AIM European Growth
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and Vanguard Precious Metals & Mining
VGPMX, +0.55%
are among the funds at those firms where shareholders face payouts. At the Vanguard fund, the capital-gains payout will be about 20% of its net asset value. Davis called that a "huge amount." A 10% payout is considered "sizeable," he adds.

This year's expected capital-gains distributions have been caused mainly by investors leaving stock funds, which forced fund managers to sell some holdings. There was a total of $204 billion in net outflows from all stock funds through October, according to research firm TrimTabs Investment Research. And the problem has been exacerbated by fund rotations, as some investors kept their money in the stock market but moved among types of stock funds. For instance, some shifted from value funds to growth strategies and others dumped small-stock funds for large-stock funds -- all actions that could create capital gains.

Making matters even worse: The tax-loss carry-forwards that many funds had from the 2000-02 market downturn were used up during the boom years from 2003 to 2006. So funds generally don't have stockpiled losses to offset any of this year's realized gains.

Some fund managers will avoid capital-gains payouts by selling securities that have fallen in value since purchase along with others that have risen. Still, we're heading for the first year since the 2000-02 periods in which the stock-fund universe posts negative returns but realizes capital gains.

'Silver lining'

Over the next few years, however, this year's market meltdown is likely to result in a new build-up of tax-loss carry-forwards -- losses that may protect some investors from capital-gains distributions for years even as the stock market recovers.

"It's the silver lining" of a market downturn, said Tom Roseen, senior analyst at research firm Lipper. In selecting a fund to buy, if "we like the management, we can use the tax-loss carry-forward" to hopefully get good performance without any associated capital-gains payouts for some time.

Roseen said some savvy fund companies may even highlight their tax-loss carry-forwards to attract investors -- essentially, advertising their "tax efficiency" as a way of improving returns.

He believes there could be a repeat of what happened after the technology bubble burst in 2000. Tax-loss carry-forwards helped drive down capital-gains distributions, which fell from a high of just under $300 billion in 2000 to about $38 billion in 2001, and $9 billion each in 2002 and 2003.

Even as the stock market started to boom, tax-loss carry-forwards kept tax bills low; capital-gains payouts didn't approach the 2000 level until 2006.

Because this year's market meltdown has been so broad-based, investors will find that most types of stock funds have tax-loss carry-forwards. The amount of a fund's tax-loss carry-forward can be found in its annual report. The publication dates of mutual fund annual reports vary depending on the fund's financial year.

Strive for efficiency

While a tax-loss carry-forward is a way to make the most of previous years' losses, tax efficiency is a strategy that investors can start using at any time. Tax efficiency is an attempt to limit the bite that taxes take out of your investment returns, such as by delaying the payment of taxes for as long as possible.

Tax efficiency came to prominence after the publication in 1993 of a research paper that highlighted the impact taxes can have on returns. "It was then that the lights went on" in the fund industry, said Don Peters, manager of tax-managed funds at T. Rowe Price Group
TROW, +1.97%
"Nobody at the time was paying any attention to taxes."

The value of delaying tax hits will rise if capital-gains tax rates are increased. During the presidential campaign, President-elect Obama said he would raise the top long-term capital-gains rate to 20% for families making more than $250,000 a year, or $200,000 for individuals. Last week, he said his economic advisers will help him decide whether to do so by repealing existing tax breaks quickly or by allowing the Bush tax cuts to expire at the end of 2010.

Joel Dickson, tax specialist at Vanguard, said there are various ways in which a tax-efficient approach can boost returns. Making the most of tax-deferred accounts can yield 20% to 30% more in your nest egg over time than if you use only regular taxable accounts, he said. This strategy is based simply on maxing out 401(k) accounts at work and making full use of individual retirement accounts and Roth IRAs.

Dickson and Peters also stressed the importance of asset location -- making smart decisions about where a particular fund should sit in your portfolio. For instance, actively managed stock funds, corporate-bond funds and high-yield bond funds should generally be in tax-deferred accounts, while municipal-bond funds, index funds and tax-managed mutual funds should generally sit in taxable accounts.

"As a rule of thumb, don't put an actively managed stock fund in a taxable account," said Dickson. This is because these funds are rarely managed for tax efficiency. Dickson said asset-location strategies can make a 7% to 8% difference to your returns over the long term.

Advantages of indexing

One tax-efficient option for taxable accounts is index funds. These funds have lower turnover than actively managed funds because they simply track an index -- and indexes change their composition far less often than most fund managers change their holdings.

The Vanguard 500 Index Fund has seen about 5% turnover in its portfolio this year. By contrast, the average turnover of an actively managed stock fund is about 95%, according to Morningstar.

And while actively managed funds often sell stocks after they've appreciated, an index fund usually sells poor-performing stocks that have been dumped from an index -- which makes it unlikely there will be capital-gains distributions.

Tax efficiency also is a feature of many exchange-traded funds. ETFs are generally similar to index-linked mutual funds in that most passively follow indexes. But they can be even more efficient because unlike mutual funds, ETFs are traded on an exchange. When investors pull out of a fund, they just sell their shares, rather than forcing the fund's manager to raise cash to pay them out.

Barclays Global Investors, a unit of Barclays PLC
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manager of the iShares line of ETFs, said in November that only two of the 178 iShares ETFs will have capital-gains distributions this year: Cohen & Steers Realty Majors Index Fund
ICF, +0.35%
which has an estimated distribution of just under 1% of the fund's net asset value, and iShares Lehman Short Treasury Bond Fund
SHV, +0.03%
which has an estimated distribution of less than 0.01%.

"It's just another feather in the cap of ETFs," said Mayflower Advisors' Glazer.

For investors who would rather buy actively managed funds in hopes of earning market-beating returns, there are tax-managed funds. These actively managed funds try to keep the tax hit low by selling some holdings at a loss to offset gains and also by holding onto stocks longer than the average mutual fund.

It's unclear whether tax-managed funds deliver better returns on average than other funds, said Morningstar's Davis. But some are attractive. He suggested Vanguard Tax-Managed Growth & Income
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and Vanguard Tax-Managed Capital Appreciation
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funds. "They both try to keep the portfolio characteristics of index funds," such as low turnover, Davis said.

Davis also recommended Vanguard Tax-Managed Balanced Fund
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one of the few tax-managed mutual funds that also invests in bonds. "It's important to be tax-efficient in bonds, too," he said. Fifty percent of the fund is in tax-free municipal bonds.

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